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"Why China will find it difficult to re-balance its economy"

Saurav Jha @SJha1618

Updated: February 26, 2014, 12:15 PM IST
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In March 2013, 16000 dead pigs were found floating in the Huangpu river that is the source of Shanghai's drinking water supply. The pigs had been culled by farmers who initially lured by China's growing meat consumption had increased livestock numbers to unsustainable levels and now found themselves incurring major costs as they looked to get rid of diseased animals from overcrowded farms. The episode clearly reveals that China's fabled governance model is not able to tide over the intrinsic problems associated with 'development' in the face of limited river basins and demographic transition. And since China adopted industrial urbanization in a 'great leap forward' the consequent landing is also digging a much bigger hole. This has implications for both China's geopolitical agenda as well what India should realistically expect from the US pivot to Asia.

Pressure over land due to competing sectors is not unique to China. It is the story of every river basin in the world that has sought to be modernized. Land by itself means little. It is land with fresh water that counts and that is precisely why humans inhabit only 8 per cent of the world's total landmass. It is the river basin that serves as a cradle for agriculture, industry or services.

After years of using its green field advantage to build both heavy and consumer industries, the Chinese are now looking at a 6.4 trillion dollar spend to further urbanize their economy. Urbanization is to be the new engine of growth. This push in many ways is continuation of policies adopted by China since 2008. Over 200 ghost cities in China attest to this fact.

Wage inflation after all is now a widespread phenomenon in China's coastal belt and many global labour arbitrage value chains are shifting out of China. For instance many Indian cell phone companies are moving out of China and locating their units on domestic shores. The shift is also very visible in the lower end of the garments sector with Bangladesh being a major beneficiary.

China's miracle economy till very recently buoyed by its ability to tap overconsuming OECD markets enabled the creation of an industrial estate that employed much more rural surplus labour than its own domestic market could have supported. Costs remained low riding on the back of extremely good infrastructure and tightly controlled industrial relations. But at the end of the day industrial relations were managed riding on the back of massive reserves of surplus labour in the countryside that were brought to industrial zones around Chinese cities under the carefully regulated Hukou system.

The party however ended with the credit bust in the west in 2008 and the drying up of surplus labour in the Chinese urban scape. It is no surprise therefore that China is now opting to have less smokestacks and ever more high rises housing banks, insurance firms and of course residences. Urbanization a.k.a real estate is always the great temporary reprieve once industrial profits slide. While brownfields are seldom viable to site new factories, they are quite readily lend themselves for re-development as glass and steel havens. This keeps the steel and cement sectors in a country humming besides creating jobs for former industrial workers employed in construction activities. And as studies in California show, the services sector generates much more employment per unit of water than industry or thirsty green revolution agriculture.

China's removal of smokestacks would also correspond with a rebalancing towards domestic consumption. China's middle class is already providing some of the ballast to shore up weak international sales. However continued consumer confidence in China will depend a lot on how much of disposable income its increasingly urbanized population will be able to deploy.

A large chunk of service sector jobs being created in China or indeed elsewhere won't exactly build or sustain a middle class. While Walmart may celebrate its entrenchment in China; the fact is big retail doesn't exactly create that many middle class jobs. The whole idea behind industrialization after all is to avail of the value multiplier which will now increasingly be less available to the Chinese population. What will be more available instead are service sector jobs that involve flipping burgers or helping out in stores that in the United States(US) has a value multiplier of only 0.71 i.e less than one. As an aside this also means that China will not give any real access to Indian high value service exports as it seeks to develop its own.

The biggest threat to consumer demand in China and indeed everywhere else therefore comes from the rise in basic living costs including that of having access to water. China's turn towards services is happening at a time when it has already overused its downstream water sources. The Yellow river known as the mother of the Han race no longer reaches the yellow sea. Drinking water shortages are routinely reported and China opened a new desalination plant in Tianjin earlier this year which will serve as a template for more such plants along the Bohai coast. This plant will supply desalinated water at a cost that is 30 percent higher than that of regular municipal water in Tianjin.

The point is that this all important resource- water- that in a rural economy did not have to be accounted for now forms an increasing component of basic costs in China. One of the ways in which the Chinese are looking to hold this cost down, is by moving upstream. The move upstream is also a move towards western china. Indeed the Chinese government initiated a 'Go west' program in 2010 that has seen a lot of injection into infrastructure development in the Chinese hinterland.

But the fact is the very real issue of water shortages are not about to go away by simply moving the developmental thrust closer to the source of China's major rivers. Not downstream anyway. It is precisely for this reason that China has instituted a 65 billion dollar program to transfer water from the Yangtse to the Yellow and Hai rivers.

Nevertheless, this project gives an indication of the kind of inter-basin transfers already being contemplated by the Chinese to deal with water stress in the economy. And when the balloon goes up in western China due to industrial urbanization it is the Brahmaputra's headwaters that will sought to be diverted because the 'rising China' theme has a penchant for large landscape altering projects rather than accepting a lower standard of living. And since costs will rise because of this fixation even diverting the Brahmaputra will be considered with its attendant consequences for decision making in India.

The water situation in China also means that despite having possibly the world's largest shale gas deposits, the middle kingdom will not be able to exploit them anyway close to potential. Indeed China which is already the world's largest importer of oil for the foreseeable future will remain dependent on external sources for its energy requirements.

For much of the last three decades China could manage rising oil prices because wage overheads remained relatively low and energy imports were used to support export oriented industries which more than paid for these imports. Now with a much more urbanized China and the commensurate increase in hydrocarbon demand to literally 'drive' suburban automobile economies complete with big box retail, the country is at a stage where it needs to find significant new resources that it can access at lower cost than it does currently. The Chinese naval build-up and aggressive moves in the South China Sea can therefore be easily understood.

In fact militarization of China's foreign policy is not surprising at all. Even on the economic side naval shipbuilding programs are a good way of climbing up the industrial value chain. China's pursuit of high technology industries will therefore continue alongside a rising contribution of these industries to China's military posture. India must therefore understand that the Chinese build-up will not necessarily be constrained by budgetary issues as it is now being seen both as an engine of growth as well as a way to remove resource limits to growth or perhaps sustenance as the case might be in the world of tomorrow.

Cheaper energy is also the key to any domestic food security strategy. Green revolution farming has only got more energy intensive over the years with greater mechanization and unchecked fertilizer use to make up for declining soil productivity. In fact China's soil quality is an 'official secret'. Of course it is little solace that the state of the soil in Punjab or in America's mid-west is no secret.

In as much as China seeks to draw water from it western periphery, machinate to seize control of energy resources in the South China Sea, it's diplomacy shows that it now looking overseas for food security.

So essentially China's adoption of first the Japanese export oriented model and then America's auto centric economy has brought it much quicker to a stage where it is water stressed with an increasingly complex food safety picture. This is basically a direct result of pursuing both models with a vengeance- something that only a Communist Party with a soviet control structure could do. In fact even the Soviet Union finally collapsed when oil prices dropped in the late eighties even as it had begun importing more than half of its grain requirements thanks to its collectivized agriculture. No wonder that China is now encouraging family farms. Meanwhile great transition in Russia has seen it become an economy with military-aerospace industries at one end and resource export at the other.

And today one is also beginning to see the US becoming a resource exporter with domestic coal and gas being put on the export market. Even with a far superior resource to population ratio in comparison to China, the US is now a major importer of food and its food processing industries use imported intermediates (especially meat) heavily. China's urban push is also seeing it become a major consumer of processed meat and that will only exacerbate its food and water woes. A tonne of beef has a water footprint 15 times greater than an equivalent quantity of rice which typically needs 1000 litres of water to process.

Ultimately what has helped keep food costs manageable in America and Europe till now are cheap imports using currency arbitrage. China if and when it becomes a major food importer due to its development process will also look at maintaining currency strength as food is brought in from across the oceans. At the moment with its massive dollar reserves China is well positioned to manage the direction of the Renmibi in terms of medium term movements. In fact since 2005, the Renmibi has steadily moved to a partial float regime and has actually appreciated mirroring China's economic path. However this has had an effect on its export competitiveness.

With time as it reorients its economy from excessive export oriented manufacturing and tries to keep costs lower in its urban areas, China would want the Renmibi to become a reserve currency. China has already emerged as an exporter of capital given its surplus reserves. But those reserves are mostly in dollars that has increasingly seen its supply increased through quantitative easing by the US Federal Reserve. Indeed some commentators in the West are calling for open monetization of US debt. This can hardly be good news to all those who hold excess dollar reserves.

At the moment, however the Renmibi is not yet in a position wherein it can emerge as a reserve currency. Yes China may have the second largest economy in the world, but it is clearly one that is witnessing inflation outstripping productivity. Moreover China does not have the power projection capabilities that the US has. Seen in one way, the US pivot to Asia is clearly an attempt to ensure that any future currency wars with China do not play out to the US's disadvantage.

The US conducted its first ever financial war game in 2009 and since then it is quite clear that the Pentagon is being woven into a strategy to protect the US dollar as symbolized by the pivot to Asia. Since that time India has on one side been paradoxically described as the lynchpin of that pivot while on the other it has tried to create a BRICS bank along with China that could settle payments and extend loans on a non-dollar basis. Without a reserve currency China will hit the austerity vs deficit spending debate in the not too distant future given the state of its domestic energy food water nexus. It also faces the tough choice of either managing inflation through cheaper imports or try and sustain exports by cheapening the Renmibi.

It has been reported that the June 2013 'Sunnyland retreat' talks between Obama and Xi Jiping have actually included American demands to allow the Renmibi to strengthen against the dollar to ease US deficit issues. Since then the dollar has strengthened against all emerging market currencies except the Renmibi. All this has taken place even as US arms exports to India grow and the Chinese adopt a more belligerent stand on the border issue. I think India needs to be very careful about choosing a side while keeping its powder dry.

For updates follow Saurav Jha on twitter @SJha1618
First Published: February 26, 2014, 12:15 PM IST

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